Research Department Staff Forecast, April 2018

This document presents the forecast of macroeconomic developments
compiled by the Bank of Israel Research Department in April 2018.[1] In terms of
the main macroeconomic variables—GDP, inflation and the interest rate—the
forecast remains unchanged relative to the forecast published in January. According
to the staff forecast, gross domestic product (GDP) is projected to increase by
3.4 percent in 2018 and by 3.5 percent in 2019. The rate of inflation over the
next year[2] is expected
to be 1.1 percent. The Bank of Israel interest rate is expected to remain at
its current level of 0.1 percent over the first three quarters of the year, and
to increase to 0.25 percent in the fourth quarter of the year.

Forecast

The Bank of Israel Research Department compiles a staff forecast of
macroeconomic developments on a quarterly basis. The staff forecast is based on
several models, various data sources, and assessments based on economists’
judgment.[3] The Bank’s DSGE
(Dynamic Stochastic General Equilibrium) model developed in the Research
Department—a structural model based on microeconomic foundations—plays a
primary role in formulating the macroeconomic forecast.[4] The model
provides a framework for analyzing the forces that have an effect on the
economy, and allows information from various sources to be combined into a
macroeconomic forecast of real and nominal variables, with an internally
consistent “economic story”.

a.The global environment

Our assessments of expected developments in the global economy are based
mainly on projections by international institutions (the International Monetary
Fund and the OECD) and by foreign investment houses. These institutions revised
their forecasts for growth and inflation in advanced economies and for world
trade upward compared to their previous forecasts. Accordingly, our assessments
are that growth in the advanced economies will be about 2.5 percent in 2018 and
2.2 percent 2019, and that imports to the advanced economies will increase by 5.0
percent in 2018 and by 4.9 percent in 2019. According to the assessments of
investment houses, the US federal funds rate is expected to increase to 2.4
percent at the end of 2018 and 3.0 percent at the end of 2019. The declared interest rate in the eurozone is
expected to be 0.0 percent at the end of 2018, and 0.3 percent at the end of
2019. Additionally, our assessment is that inflation in the advanced economies
will reach about 1.9 percent in 2018 and in 2019. Oil prices continued to increase
in recent months, with the average price of Brent crude oil reaching about $67
per barrel in the first quarter, compared with an average of $61 in the fourth
quarter of 2017.

b.Real activity in Israel

GDP is expected to grow by 3.4 percent in 2018 and by 3.5 percent in
2019 (Table 1). Our assessments of forecast real developments in 2018 and
2019 are essentially unchanged from the previous forecast. Fixed capital formation is expected to
increase by 3.0 percent in 2018, in view of the slowdown in investment in
residential construction, as can be derived from the relatively low level of
building starts in 2017. Investments are
expected to increase in 2019 due to a number of large investments (import-oriented)
in various industries. Exports are
expected to continue increasing, inter alia because world trade is expected to
continue its recovery, and in view of the maturation of a number of investments
in various industries. Changes in vehicle taxation are expected in January 2019[5], and our
assessment is that they will lead to vehicle purchases being brought forward,
which will be reflected in growth figures for 2018 (similar to the development
that was observed in previous years).

c.Inflation and interest rate
estimates

According to the staff forecast, the inflation rate[6]
in 2018 will be 1.1 percent and at the end of 2019 it will be 1.4 percent. This
forecast reflects the assessment that inflation will increase moderately toward
the center of the target range. The main
contribution to inflation is expected to be from the tight labor market, which
will be reflected in wage increases. In contrast, the continued increase in
competition and measures taken by the government to lower the cost of living
are expected to continue to moderate inflation.
In our assessment, the prices of nontradable goods and services are
expected to continue making a positive contribution to inflation, and in
particular we expect that the rents item will be prominent despite moderation
in its rate of increase in recent months. The pace of increase in the prices of
tradable goods is expected to rise due to the increase in inflation globally,
particularly the increase in energy prices, assuming that the shekel’s exchange
rate remains relatively stable. However,
long-term price trends of tradable goods and structural processes (such as the
development of Internet commerce), as well as expected additional government
measures will moderate the increase.

According to the Research Department’s assessment, the Bank of Israel
interest rate is expected to start increasing in the fourth quarter of 2018,
following the increase of the annual inflation rate to within the target range,
and as the inflation expectations at that time will also be within the
inflation range.

Table 1

Economic Indicators

Research Department Staff
Forecast for 2018 to 2019

(rates of
change, percent, unless stated otherwise)

2017

Bank of Israel forecast for 2018

Change from the previous
forecast

Bank of Israel forecast for 2019

Change from the previous
forecast

GDP

3.3

3.4

-

3.5

-

Private consumption

3.3

4.0

-

3.0

-

Fixed capital formation (excluding ships and aircraft)

3.1

3.0

-

4.5

-2.5

Public sector consumption (excluding defense imports)

4.3

1.5

-0.5

2.0

-1.0

Exports (excluding diamonds and start-ups)

5.7

4.0

0.5

6.0

-

Civilian imports (excluding
diamonds, ships, and aircraft)

6.9

5.5

1.5

5.5

-2.0

Unemployment ratea

3.7

3.1

-0.5

3.1

-0.5

Inflation rateb

0.3

1.1

-

1.4

-

Bank of Israel interest ratec

0.10

0.25

-

0.50

-

b) Annual average of
unemployment in the primary working ages (25–64).

c) Average CPI reading in
the final quarter of the year compared with the final-quarter average in the
previous year.

d) End of the year.

Table 2 indicates that the forecasts compiled by the Research Department
regarding inflation and the interest rate in the coming year are higher than
the projections of private forecasters and expectations derived from the
capital markets. However, according to the forecasters and market expectations,
there is some likelihood of an increase in the interest rate during the coming
year.

Table 2

Inflation and interest rate forecasts
for the coming year

(percent)

Bank of Israel Research Department

Capital markets

Private forecasters

Inflation ratea

1.1

0.6

0.7

(range of forecasts)

(0.3–1.8)

Interest rateb

0.25

0.16

0.13

(range of forecasts)

(-0.10–0.25)

a) Research Department: average CPI reading
in the first quarter of 2019 compared with the average in the first quarter
of 2018. Forecasters: Average
forecast of inflation in 2018 published following the publication of the CPI
for February 2018.

b) Research Department: in the first quarter
of 2019. Expectations from the capital market are based on the monthly
average forward Telbor rates for 9–12 months. Forecasters: As published following the
publication of the CPI for February 2018.

d.Risks in the forecast

Several factors may lead to the domestic economy developing differently
than in the baseline forecast. These include uncertainty concerning the future
development of the exchange rate, as well as uncertainty concerning the extent
to which government measures to reduce the cost of living will roll over to
prices and regarding the strength of further measures of this kind that the
government may take. In addition, even
though the forecast takes into account the continued increase in competition in
the economy, there is uncertainty from a quantitative standpoint regarding the
strength of the increase and its continued effect. Regarding the global
environment, while the growth forecast and world trade forecast have been
revised upward, recent developments in world trade may worsen to the point of a
trade war that may have a significant impact on the Israeli economy, which is
small and open.

Figures 1 to 3 present fan charts around the inflation rate, interest
rate and GDP growth forecasts. The center of the fan (the white line) reflects
the Research Department’s staff forecast. The broken line represents the
baseline forecast from the previous quarter. The width of the fan is derived
from the estimated distribution of the shocks in the Research Department's DSGE
model, and the fan encompasses 66 percent of the expected distribution.

Actual GDP Growth Rate in the Past
Four Quarters and Fan Chart of Expected Growth Rate

(Total GDP over the past four quarters
relative to GDP in the preceding four quarters)

Regarding GDP growth (Figure 3), until December 2017,
the dotted line reflects the data and estimates that were known at the time
when the previous forecast was formulated, while the solid line reflects the
updated data and estimates (the difference between them derives from new data
and revisions to the data by the Central Bureau of Statistics).

[1] The forecast was
presented to the Monetary Committee on April 15, 2018 during its meeting prior
to the decision on the Bank of Israel interest rate reached on April 16, 2018. Around the time of publication of this
forecast, it was announced that the Israel Tax Authority intends to delay the
revision of the tax formula for vehicles to the middle of 2019. The current forecast does not take this new
information into account.

[2]The average CPI in
the first quarter of 2019 compared with the average in the first quarter of 2018.

[3]An explanation of the
macroeconomic staff forecasts compiled by the Research Department, as well as a
review of the models on which they are based, appear in Inflation Report number
31 (for the second quarter of 2010), Section 3c.

[4]A Discussion Paper on the DSGE model is available on the Bank of Israel
website, under the title: “MOISE: A DSGE Model for the Israeli Economy,”
Discussion Paper No. 2012.06.

[5]According to the
National Accounts recording rules, taxation on imported vehicles is included in
GDP. These imports also contribute to
GDP through their effect on importers’ added value. Around the time of
publication of this forecast, it was announced that the Israel Tax Authority
intends to delay the revision of the tax formula for vehicles to the middle of
2019. The current forecast does not take
this new information into account.

[6] Average CPI reading in
the final quarter of the year compared with the final-quarter average in the
previous year.